Investment Taxes: Pay Up Front or Defer Until Retirement?

by Jeff Reeves | January 25, 2013 10:28 am

There are a lot of complicated issues involved with investing. Most people see this as daunting, since there are no universal truths for retirement savings. But the flip-side is that it allows flexibility. Every family has its own personal needs and chances are there are plenty of tools that fit your needs very well — if you craft a plan and identify the proper ways to follow it.

One important starting point for any investment strategy or retirement plan is the issue of taxes — namely, to pay them now or pay them later.

Most vehicles investors are familiar with such as a traditional IRA or an employee-sponsored 401k plan involve deferring taxes until you need the money. But is it always wise to kick your tax obligations down the road?

Let’s take a look:

Benefits of Tax-Deferred Investments

The idea behind deferring taxes isn’t just kicking the can down the road for the sake of keeping the IRS at bay. Here are the benefits:

Reduce Your Annual Tax Burden During Your Working Life: Saving for retirement saves you on your taxes, so it’s a win-win. Contributions to a 401k or IRA can reduce what you owe the IRS each year in the same way itemizing charitable deductions, healthcare expenses and child credits can.

Taxes Paid Later in Life Will Probably be Lower: In the vast majority of cases, your tax rate on those retirement funds will be far less than what you would pay now. Consider that after hitting 59 years and 6 months you can cash out 100% of your 401k plan and pay just a 20% rate on the withdrawal under current tax law. For wealthy families now paying a top income rate of 39.6%, that’s quite a difference if you wait.

Your Tax Savings Fuel Compound Interest : Perhaps the most tangible benefits of paying taxes later is that you can put 100% of your money to work in an investment account. If you save $5,000 annually and get a 5% rate of return on your investments, you’ll have almost $350,000 in 30 years. But if you save just $4,000 each year because the IRS is eating up about $1,000 in up-front taxes, you’ll have $280,000 in the same time frame and at the same rate of return. In short, keeping just a little bit more of your money and putting it to work over time can make a big difference in the long-run.

When Taxes Up Front Make Sense

The vast majority of Americans hold traditional IRAs or 401k plans because of these very tangible benefits. Of course, there are a few cases when it does make sense to pay taxes on the front end and invest in vehicles like a Roth IRA or even a brokerage account.

Here are a few:

You’re Young and Responsible: Remember, most people wait until they have good-paying jobs to start planning for retirement. But what if you’re 16, working at a fast-food joint and making only several thousand dollars annually? Your tax rate is rock bottom so paying taxes up front could be wise — especially considering the power of compound interest over an extra decade or two, and the fact that Roth IRA withdrawals can be used before retirement to pay for your first home.

You Want to Spend the Money Sooner: Keep in mind that there are severe penalties for withdrawing tax-deferred retirement funds in your late 40s or early 50s. So if you want to invest with an aim of quitting working early — or just want the flexibility to tap into your investment gains for a nice vacation or home remodel — you may have no choice but to use a taxable brokerage account.

You Have Maxed Out Tax Deferred Options: If you want to retire in style, sometimes you’ll have to save more than the IRS allows you to write off. Consider a traditional IRA offers most folks a $5,000 cap on deductions. So what if you want to save more than $5,000? You could of course plow more into the tax-deferred IRA without a tax benefit, but without that sweetener the vehicles that make you pay taxes up front may not look as unappealing anymore.

Remember, the bottom line is that all investment and retirement decisions are intensely personal. Any moves should be based on your specific finances now, your family’s future goals and any unexpected occurrences life can throw your way across the 20 or 30 years between now and retirement. If you find yourself in a sticky situation with no easy answers, perhaps the best investment you can make is to hire a qualified tax and retirement professional to advise you on the proper course of action.

Jeff Reeves is the editor of InvestorPlace.com[1] and the author of The Frugal Investor’s Guide to Finding Great Stocks[2].